Accrual Vs Cash.. Interesting

[geekgirldany]

As some of your know a customer is going through a audit. A CPA is handling it but the customer keeps me up to date on what is going on.

Well today he called telling me that the auditor is wanting to convert their accounting method from cash to accrual. This is very troubling to say the least. The company builds custom cabinets. The keyword here is custom.

The CPA is advising the client to go with the auditor to switch the accounting method. He says it is possible they will have to go to court to contest it. I told the client in my opinion they are entitled to the cash basis. Here are my reasons:

1. Revenue Procedure 2002-28 (http://www.nysscpa.org/cpajournal/2004/104/text/p32.htm). The under 1 million rule you can use the cash method.

2. It is a custom manufacturing company. The cabinets are built to order. They do not hold cabinets in inventory for the public to buy. They only sell to contractors/home builders.

3. Insurance will not cover the loss of inventory because they are in a flood area. So they do not keep large amounts of inventory.

4. Materials are purchased when they get the job. Some small amounts of material maybe be left but not enough to complete a full job.

5. Jobs are completed alteast two weeks before the end of the year. Amount of inventory left over is very small amount. Between $500 to $1500.

6. Materials are not bought in bulk at the end of the year. To my reading some companies buy alot of materials to get the write off in december but then do not complete/report the money received from the jobs until the next year. This is actually stated in the IRS MSSP manual for Manufacturing for a agent to look for during a audit.

7. Cabinets are not in inventory. The custom build cabinets are not left sitting around at the end of the year.

==============

I feel like they have a good case. The CPA is really wanting them to go with the change just to get the audit over. This is all that the auditor has brought up during the whole audit. The client actually had me fax the Revenue Procedure 2002-28 to the CPA.

I found this during my research today:

http://www.nysscpa.org/cpajournal/2001/0800/features/f083201.htm

This shows several court cases won and lost on changing the accounting method.

I would like to know your opinions on this and I think it would just be a good topic to discuss.

[jainen]

Why fight?

If he doesn't hold any significant inventory, does it make that much difference in his tax?

[Snaggletooth]

Cash - Double-edged Sword

Geeko, I've always been a big fan of the accrual method for accounting purposes, but not necessarily for tax purposes.

If I wanted to stay on the cash basis, I would first find out whether that particular industry REQUIRES accrual treatment. If not, that would be reason enough. From what you tell in your post, I don't think accrual method is mandatory for taxes.

HOWEVER, remember what you lose with the cash basis, and make your decision accordingly. Firstly, if this customer is growing and has debt, the bank may someday require an audit or a review. When that happens, cash basis will not be in accordance with GAAP. The "cure" for this problem is to 1)do double-accounting under both methods, and 2)recognize a timing difference as a tax liability. None of this is fun, but CPAs make a lot of money doing all this extra work.

Listen to Jainen's point above -- if (as you claim) inventory is so small, then the dollars involved in the dispute are small as well. If you want to change LATER to the accrual method, you will have to pay IRS a $900 user fee -- if you agree now, this auditor will do it for you free.

Also, with respect to your "custom work" reasoning, I still can't buy into the idea that there will be no significant inventory on each December 31. Maybe your inventory is slender for the year in question, but even with "custom" jobs, the more expensive outlays for custom work and materials can often offset the lack of mass.

If there IS significant inventory in some years, the insistence on "Cash Basis" will create an irregular "peaks and valleys" income pattern for your client. Over the long haul, this means MORE taxes.

GeekGirl, this is a great topic. I hope others will respond as well. Fight for your cash basis if you must, but consider the overall picture -- accrual is not that bad, and often preferred.

Regards, Ron Jordan

[geekgirldany]

accounting method

Thank you guys this should be a good discussion.

Client actually sold the business S-Corp in Jan 05. Business is well established and the only debts are that of truck loans. But now that gets into another area where the new shareholders are paying for the purchase of stock... but like I said that is a whole other thing. But probably needs to be looked at.

I looked back up to 2000 and each year the inventory was just that between $500 to $1500. The way this was done was a little strange. Customer has always used quickbooks. When they buy the material to build the cabinets they don't allocate to one certain item. It has always been put under purchases. Any inventory was put down as a general journal entry adjustment. This would show up as a negative figure under Purchases but a postive amount under the balance sheet. According the client this started with their first accountant.

After looking at quickbooks it appears that they would actually have less income in accural. Atleast for a few years. Prior to those years there is actually more reported in accural than cash.

If this was changed to accural. Would all previous years also be changed?? Would the auditor think twice about changing it if he sees less income?

They want to keep it cash basis because of the new shareholders but also of the possibly tax liability.

[Lance Emerson]

Without having studied the Rev Procs in detail, I think that 2002-28 might not be the right one. There are ineligible NAICS codes that include wood product manufacturing. Try this one.

"REV. PROC. 2001-10

"SECTION 1. PURPOSE

"This revenue procedure modifies and supersedes Rev. Proc. 2000-22,
2000-20 I.R.B. 1008, and provides that the Commissioner of Internal
Revenue will exercise his discretion to except a qualifying taxpayer with
average annual gross receipts of $1,000,000 or less from the requirements
to use an accrual method of accounting under section 446 of the Internal
Revenue Code and to account for inventories under section 471..."

Keep in mind that the cash basis of accounting does not allow the taxpayer to write off inventory costs before the inventory is sold. Even under the cash method, if there is inventory, the inventory is accounted for in the same manner as materials and supplies which are written off the later of when the materials are used or when they are paid for.

There is inventory even if ending inventory is always zero.

The major difference between the cash and accrual methods in accounting for inventory doesn't have to do with when the costs are deducted. It has to do with whether accounts receivable are included in income. Under the accrual method, the income must be reported when the products are sold. Under the cash method, the income isn't reported until received. Under both methods, the cost of the inventory is not written off until the product is sold.

[JON]

Points

To go to full accrual there is more than inventory involved. Even if inventory is small how much does accounts receivable and prepaids exceed the accruals? If accrual is elected than you are a manufacturer and 263 comes into play. Even if you are on "cash" you are supposed to show invenorties of materials as a prepaid expense - asset.

If business was sold in Jan 05-who even cares, unless it was s stock sale-then keep cash even if you go to appeals. All those CPAs are just terrible.

[Gretel]

Ron

If there IS significant inventory in some years, the insistence on "Cash Basis" will create an irregular "peaks and valleys" income pattern for your client. Over the long haul, this means MORE taxes.

First time I am trying to quote. Hope it works.

Ron, can you explain what you mean by this? I thought the inventory doesn't make any difference since also on cash basis you have to account for it. What am I missing?

I understand that if you have "peaks and valleys" that this means more taxes but I don't understand how inventory comes into play here.

[Snaggletooth]

Peaks and Valleys

Gabriele and others, I'll try to wade through this as best I can.

Firstly, Lance Emerson has made the point that creating deferred costs in inventory is not the same as embracing the accrual method. He is, as usual, technically correct. However, the confrontation/explanation with the client is reduced to the same thing - namely, claiming income and costs based on cash receipts and outlays versus true measurements which include receivables and inventory. Other accrual-related items pop up as well, such as "percentage of completion" revenue, and Payables (be they for taxes, payroll, or purchases).

I often refer to the "peaks and valleys" as a "sawtooth" pattern. Profits which resemble a snapshot of the Grand Tetons.

A "sawtooth" pattern results when the profits pumped into an organization on a consistent basis are distorted by methods of measurement that focus on things other than profit. Cash is perhaps the most common focus that distorts true earnings. December 31 is the snapshot we have to deal with, and the forces creating this distortion are legion. Here are a few:

1) A very profitable job which will yield $750,000 versus a cost of $500,000 is almost
finished. The builder has spent $500,000 already, but has billed/collected only
$400,000. The effect of this is that he has earned a profit of $250,000 but will report
a $100,000 loss on the cash basis. In that that year he has underreported by $350K,
and the following year he will overreport by $350K. I don't think we're looking at the
Grand Tetons anymore -- this is more like the Half Dome in Yosemite.
2) It's Christmastime and the plant shuts down and the billing clerk goes on a well-
deserved vacation. During the last week of the year the mail goes unopened and
some $125,000 in cash receipts go unrecorded until January 2nd. The next year,
the billing clerk decides NOT to go on vacation but keeps the office open. Yep,
another sawtooth created by the cash method.

If you want your clients to pay the minimum tax over a period of years, you'd best keep him out of Tetons, and direct him to the flatlands of the Mississippi Delta.

Of course I have contrived the above examples to be rather extreme just for emphasis, but at the end of every year, very significant such phenomena exist more often than not. These are just two of an untold number of scenarios which are the "rule" in our commerce, and not the "exception."

The original post claims only some $1500 is involved in inventory, but if the accrual method were truly applied, I'll bet the effect is much more due to receivables, payables, percentage-of-completion, and particularly "work-in-process" and inventoriable overhead which requires more sophisticated cost accounting than most small companies care to fool with. In fact, much of this stuff is more "GAAP" than "tax" and it's hard to convince small company owners that the sophisticated stuff is worth their time and money. For that reason, I often do accrual adjustments with very broad brush strokes and leave the intricate stuff alone.

[geekgirldany]

Thank you all for the informative posts.

Lance you are correct Revenue Procedure 2001-10 does really cover it more. I had bookmarked several of these on my business computer but couldn't track that one down again on the home computer.

Ron you made a excellent post regarding the up and downs of cash basis. I can see what you mean exactly. And I understand now about inventory still has to be accounted for on a Cash basis. This really does come into play with "work in progress".

Comparing Cash vs Accural... just in Sales... the first 3 years of the business the Accural Sales are more than Cash sales. Then from 2000 on Cash Sales are more than Accural Sales. I'm still wondering if he would only change one year?

[Gretel]

Ron, again

Thank you so much Ron. Yes, I agree with you, almost fully. Smile.

Your examples really help to see what you mean and that you were actually talking more about the other aspects of accrual vs. cash then inventory. Since also the cash method requires accrual for inventory and "work in progress" (and yes it's tedious cost accounting and I love it, have one small business who really cares about it) it's doesn't make much difference if you use cash or accrual.

Your first example is great and, yes, this happens all the time.

Your second one is probably done a lot even though once you have the cash constructively received you need to include it in the year received. So if done correctly having the bookkeeper take a nice vacation doesn't make any difference.

Am I just picky?

[Lance Emerson]

Snaggle presented a good dissertation on factors to consider in choosing between the cash method and the accrual method, all good points. However, I believe the points were made in the context of tax planning. In this case we're not dealing with the options available in choice of accounting method.

We're dealing with an auditor who is attempting to force the accrual method. Whether that ends up as a sawtooth or not is moot. If the accrual method is forced, it's a reality, regardless of what kind of fluctuations result. The change to accrual will cost the client money, and there is a legitimate possibility that the change should not be allowed to happen under Rev Procs.

This isn't a matter of timing, because the company was sold. In fact there might be zero change in net tax over the tax periods we're talking about. The main issue is not about shifting tax from one period to another. It's about shifting tax liability from one person to another (new owners). If the timing of those receivables are shifted to a period when the client owned the stock and received the flow-through income, that much tax will be shifted away from the new owners and onto the old owners. If that happens it will boil down to the new owners having purchased a business that was more valuable than anyone thought at the time.

[geekgirldany]

Update

Meeting with auditor last week. Client called today. Auditor said he was taking it to his supervisor to review. CPA told him the client was not inclined to change to accural method. Client told me that the CPA is more or less standing with the auditor because he considers them to be manufactuers. Again the clause of them being "custom" manufactures and the Rev.Proc. is showing that cash basis can be used.

Did the CPA not see what I faxed him?

[dmj4]

What businesses "required" to use accrual?

One of the posts said something about some businesses being required to use accrual. Is this something other than meeting the Gross Receipts exception? If so, where can I find this information? I have a market that is coming up on audit. They have been using the cash method. Gross Receipts are less than 1 Mil and they have no account receivables.

One more thing, please. Do any of you go ahead and make changes to the return after going back through the receipts in preparation for the audit? I had an audit a few years ago and I did change the return and it worked to our advantage. I found expenses the client had not claimed and we started the audit with a refund due us. It left the auditor with nothing left to change except the % of business use for the vehicle. We agreed and we still had a refund.

TP has noticed she purchaed $10,000 in inventory that she did not put on the original return. This is actually not a good finding because they got some EIC and Additional Child Tax Credit so the extra purchases will make them owe money. She has admitted that she does not have a mileage log. I could take the mileage off, due to no documentation and that would even things back out some, but that would seem like an EIC balancing act. Which I guess that it would be. I just feel like the IRS would disallow the mileage if it were a no EIC return, but since disallowing the mileage would get a larger refund they will probably let it stand. Or I could just leave it on and not have any documentation, maybe the auditor would be forced to take it off herself.

Mostly, I don't want to do anything that would seem like EIC fraud.

[RLymanC]

Mileage & EIC

Small Schedule C filers have claimed mileage and it reduces EIC. The IRS requires written log or at least some form of substantiation. Taxpayer can't come up with a thing.

I delete the mileage and he gets an increase in EIC. The IRS can't have it both ways.